The more I practice the luckier I get...

I saw this week that a chap by the name of John Meriwether, a bell-weather name of the hedge fund world, is about to embark upon his 3rd attempt at running a hedge fund. Incredible really. This guy's "ability" required the Federal Reserve to establish the entire precedent of "too big to fail" in 1998, when they were forced to rescue his first hedge fund, Long Term Capital Management (and the banks that lent to it). He then had another cut at punting other people's money, which ended 3 months ago - investors in JWM Partners were handed back 56% of their initial investment. And now, like a Phoenix from the flames, he's back again with the collection bowl out raising money for a 3rd fund. The most wonderful point is that the fund is expected to use the same strategy as both LTCM and JWM Partners to make money: so-called relative value arbitrage. If this guy succeeds in raising any meaningful size of funds, he really should turn his hand to selling something easier - like ice to eskimos.

Meriwether, will undoubtedly justify his past failures as having been so-called "Black Swan" events - i.e. that the circumstances that led to these funds' demise were epoch making events, which could not possibly have been foreseen. In the first case "irrational" market movements following the Russian crisis in 1998, and in the most recent case a credit market that lost its "rationality". The common theme being a basic lack of human rationality when it mattered - wow, never would have seen that. This guy must be the unluckiest guy on the planet if he has been hit by 2 once-in-a-millenium events in the past 12 years. Surely third time round he can't possibly be as unlucky?

I can only hope that those managing money in pension funds and insurance companies around the world will see this guy for what he is - not "unlucky", but just someone who isn't actually very good at understanding financial markets. To quote George Bush: "Fool me once, shame on you - shame on you. Fool me - you can't get fooled again." You get the picture.

In all likelihood Meriwether will manage to raise a goodly chunk of money for his 3rd fund, from another round of deluded asset managers and high net worths with more money than sense (I can't believe any original investors will go back for a 2nd or 3rd roll of the dice - but who knows). Here's how the conversation will go: "No way he can be wrong a third time!! We have a rare opportunity to add this really smart guy to our stable of fund managers. Let's give him $250 million."

If you compared Meriwether to an airline pilot, or a doctor, or any other profession that I can think of, he would be struck-off whatever register of professional standards existed for that industry, as would the asset managers who chose to bet their funds on such a track record.

The fact that he can raise a second or, now third fund, helps demonstrate to me that the world is fundamentally pretty poor at analysing luck, good or bad. A fact which I think applies in all aspects of life - from financial management, to health, to relationships. In Meriwether's case, investors who are willing to invest money with him have obviously accepted that he had a decent strategy, but was just tremendously unlucky (twice).

In other worldly situations, we might think someone was lucky when their achievements have been the result of real personal impact and talent, and conversely, there are situations where someone has been affected by luck, but observers put it down to their own personal impact and ability. In other words, we get a bit confused when it comes to judging where luck does or doesn't exist. Usually success is a combination of impact and luck. (I've stolen that from here: http://docs.google.com/View?id=dgrdmfgk_33d42brbs5 - thanks bro!)

When Rudy Giuliani became mayor of New York, for example, the crime rate in the city dropped precipitously in the following couple of years. Observers put this down to the "zero tolerance" attitude that he had adopted to crime, which was widely lauded. It's been suggested recently, however, that he may just have been lucky - 18 years prior to Giuliani's election, the ground-breaking Rowe vs. Wade abortion case meant that abortion became legalised in some US states, New York included. The unobserved "luck" for Giuliani was that many of the would-be criminals had not been born 17-18 years previously - many of the aborted children would have been born into broken homes, or family environments where care would have been difficult; which statistically would have increased the probable propensity towards crime in later life.

All this led me to think of two books - one that I'm currently reading, and one that I read recently. Both address the analysis of our notions of success. In Outliers (currently reading), by Malcolm Gladwell the idea is that success is a lot more haphazard than people would tend to think. Similarly in Fooled by Randomness, a former options trader - Nassim Taleb - presents an account of the role of chance not only in personal life, but also in theoretically quantifiable spheres, such as making investment decisions - and further how much it costs society to underestimate the probability of the sort of "Black Swan" events that John Meriwether was hit by. Taleb hammers home the point that the rich (as one measure of success) are frequently just lucky rather than smart.

If you have enough participants flipping a coin, 1 of them will flip heads 10 out of 10 times. There are plenty of successful hedge fund managers who've flipped heads 4-5 times and been hailed as geniuses, and like Meriwether (before his 'bad luck' set in) have raised vast sums of money on the back of it. The truth is that many of them have been lucky, and they have a 50-50 chance of flipping a tail the next year.

The 20 year plan...

There is an amusing TV advert for Walls sausages doing the rounds at the moment, that as a recent entrant into the world of parenthood and the ensuing sleepless nights, has struck a chord. The advert shows 2 scenes; the birth of a child and, secondly, the departure of said child from home 20-odd years later. The tagline for the sausage company is: "Wall's sausages: we only select the best bits". A bit harsh maybe, but with a 3-month old son, who's lovely, but at the same time a 20 odd year financial liability, I can get the gist. I've been doing some thinking of late about what sort of assets will have value over that sort of timeframe. In trying to select the best bits, there's not a lot that's obvious to me.

As I've blogged before, I'm not much of a buyer into the current rally in stock and bond prices, so they are a bit of a no go area. Endless streams of central bank liquidity, and the transfer of private sector losses onto government balance sheets has so far postponed a reckoning for the flawed global economic approach. Governments are pursuing what should and will ultimately be highly inflationary monetary policies. The US monetary base (coins, paper money and central bank reserves) at the end of August 2008 was about $800 billion. In response to the economic crisis, the US government has printed so much money that the monetary base has swelled to $1.7 trillion. This is the largest expansion in history and a staggering devaluation of the dollar, even if that devaluation is yet to be properly recognised within financial markets.

It means that for every dollar in America one year ago, the US government has created 2.1 more of them. At some point in time, and perhaps not for some time, there must be a serious bout of inflation or increased taxes, or both; these are the only 2 conceivable ways in which governments will extract themselves from their debt burdens. For the time being, in the "postponement period", it's possible to remain comfortably deluded; in countries where substantial stimulus packages have been promised, much of these monies are yet to be put to work - so the delusion period may run for some time.

In the context of the 20 year time horizon I'm thinking of when I plan for our son's future, I'm pretty sure the proverbial will have hit the fan sometime between now and then. With that in mind, I am looking for long-term fundamentals that will almost certainly play-out over an extended time period.

The obvious suggestion, given my views, is to put money into gold - as a hedge against inflation and the effects of a weak dollar. As I've written before, I can't fully get my head around that - since the US broke any direct linkage between the dollar and gold 38 years ago, gold's relevance should theoretically have waned. Granted, the supply of gold is limited and it has been an excellent store of value for centuries, but I can't get a proper grasp of the fundamentals. The only reason it seems to be so popular is for reasons that are no longer relevant - it's a 1000 year fad, that may continue for another 1000 years, but I can only partially rationalize why this fad continues. There is a chance that gold hits a tipping point - unlikely - but possible.

So here is where I am at so far on this quest. Inspiration was provided in the form of a recent David Attenborough nature program in which he said that since he had started making nature documentaries, that the worlds population has doubled. A fairly striking fact.

The world's population has risen from 2.5 billion in 1950 to 6.8 billion. It is growing by 75 million a year and is almost certain to exceed 9 billion by 2050. Thirty years ago half the world's population were not even participating in the world economy, and now they are trying to live like we do; consuming in the same expansive ways. That emerging megaforce will put a substantial squeeze on commodity prices - in particular on basic food stuffs, like wheat. The average daily per capita consumption of oil in the US at 0.677 barrels (an amazing 26 gallons per day)., vs. India's infinitely smaller consumption (0.021bbl.s) and China's (0.049 bbl.). Even if the Chinese and Indians just start consuming as much electricity as Koreans now do, the price of oil will take off. As a fairly fundamental farming input, the knock-on effect for agricultural commodities is likely to be substantial.

It's clear that the world is in the early stages of an unprecedented explosion of the middle class, and the pace will likely pick-up significantly. India and China, where half the world's population live, are a the center of this movement. A recent Goldman Sachs report suggested that India's percentage of people in the "middle class" increased from 1% in 2000 to 5% today, but if growth conditions along the lines of their projections become reality, the vast majority of Indians could be in this group by 2040. One characteristic of "middle class" Indians or Chinese, for that matter, is that they are much more likely to have meat as a regular part of their diet. It takes 9 times as much wheat to put meat on the table (feeding pigs/cows etc.), than to put bread. What seems inevitable is that as the global population continues to grow exponentially, and as the world's middle class grows, the pressure on basic food supplies is only going to increase.

Now this I can rationalize, even if it does scare the hell out of me. Maybe farmland is the answer to financing our son's future, and an early enrollment in agricultural college. Back to his Irish roots!

Party Pooping...

The IMF this week said that they think that the world's banks are still yet to acknowledge over half of the losses that they projected in April this year. Their projected figure was $2,800bn back then, and in their latest financial stability report that figure remains their expectation. So far during the financial crisis the world's banks have acknowledged $1,300bn of writedowns, leaving another $1,500bn of losses to be accounted for - if the IMF are to be believed. At the same time, one of the main topics of regulatory discussion is how insufficient bank capital was under the old regime, and how it needs to be greater in future.

Basically regulators want banks to be better capitalised. If for example banks were forced to return to the average tangible common equity to assets ratios they had in the 1990s, then US and European banks would need to raise upwards of $1,000bn. So, adding that number to the IMF number of unaccounted-for losses, is a simple calculation adding to a fairly mind-blowing figure of $2,500bn.

That's $2,500bn worth of equity capital. Even if the real number is much less than that, what is patently clear is that the world is going to have to de-lever significantly. If we held things constant and assumed that banks lend something along the lines of 12 times equity (a conservative estimate given that Lehman Brothers were around 50 times leveraged in September 2008), then that is $30 trillion worth of credit that very theoretically would have to be removed from the system before the world's banking system is back to being "well capitalised".

When you consider that number (again this is highly conceptual) in some context then the current revival of global asset prices seems a bit crass. The biggest five banks in the world have total assets of around $15 trillion, the top ten around $26 trillion and the top 50 banks in the world have a total of $62 trillion of assets. So, essentially to regain the IMF and regulators' concept of sufficiently "capitalised" we are looking at the top 50 banks in the world halving the size of their balance sheets, or more likely all of the world's banks reducing the size of their balance sheets by somewhere between 25-40%.

To reiterate - this is all very much a rough pointer to the numbers; the IMF may be way off the mark (unlikely) and regulators may not enforce capital rules to such a strong extent (more likely). Nonetheless, there is no doubt at all that banks are going to have to raise very large sums of new equity capital, whether it be to counteract write-downs or to deal with a stiffer regulatory requirement.

At the moment there are several things helping to postpone this inevitability. Firstly the real level of interest rates around the world is next to nil, so there is an abundance of liquidity available to virtually all banks to rollover their balance sheets for the short term in debt capital markets. This is helping to sustain, or increase asset prices and is as a consequence preventing the need to acknowledge further mark-to-market write downs in the short term - even the most extravagant assets of the credit boom (things like CDO equity and subprime ABS) have seen their prices rise significantly over the past couple of quarters.

Secondly, the fact that interest rates are so low has enticed retail deposit investors to ditch their savings accounts paying 0.5% and to look for higher returns in other asset markets, from stock markets to property to convertible bonds - all of these are rising as buying interest grows. Thirdly, and this is related to the first two points, banks have seen stellar earnings from their capital markets operations in the past few quarters as debt and equity underwriting, trading and mortgage refinancing activity has created big earning opportunities. This paradise has meant that banks can claim to be "recapitalising" themselves through earnings.

All of these points, I believe, are blinding the markets from the bigger picture reality that nobody is incentivised to acknowledge. Banks may see margins erode as they incur higher debt interest costs to extend their funding, and competition for savings bids up the cost of attracting deposits. Furthermore, higher deposit insurance premiums, costs from tighter regulation and the need to hold more and higher quality capital will reduce returns on equity.

The current trend is for banks and governments to suggest that they can pay off their liabilities, or increase their equity bases through earnings or growth. In both cases the scale of the growth requirement just to get back to a relatively even keel is beyond what both government bond prices and bank equity prices justify. Friday saw stock markets respond badly to the US non-farm payroll figure, and the knock-on effect on the US jobless rate which has hit 9.8%. Another statistic that should cause concern (ironically) is that the US savings rate is increasing all the time and is now at a significant high of over 8%. The growth that is required around the world to sustain our economic system needs to have a US consumer in the hot seat - they need to be spending like there is no tomorrow and buying up cheap imports from China and their cheap exporting brethren. If the US consumer is not at the party, then it's a bit like a pub with no beer.

I don't want to be a party pooper, but there seems to be an startled ostrich approach from the world's financial markets to the inevitable issues that the world's banks and governments will have to deal with. Stick your head in the sand, interest rates are low, and liabilities are on the back burner. At a fundamental level the system, by any measure, remains way over-leveraged, and ironically is actually getting more leveraged in many areas. While that makes people feel good in the short-run, I can't see how it's sustainable for the long-term.

I think it's fair to say that I'm not a buyer of the current rally!